Traceable Shares and Corporate Law

George S. Geis is the William S. Potter Professor of Law and the Thomas F. Bergin Teaching Professor of Law at the University of Virginia School of Law. This post is based on his recent article, forthcoming in the Northwestern University Law Review.

A healthy system of shareholder voting is crucial for any regime of corporate law. The proper allocation of governance power is subject to debate, of course, but everyone should be concerned with the fitness of the underlying mechanism used to stuff the ballot boxes. Proponents of shareholder power, for instance, cannot argue for greater control if the legitimacy of the resulting tallies is suspect. And those who advocate for board deference do so on the bedrock of authority that reliable shareholder elections supposedly confer.

Unfortunately, our trust in the corporate franchise was forged during an era that predates modern complexities in the way that stock ownership is now tracked and traded. We do not trace shares, and any clear-eyed look at the conferral of voting rights via back-end stock clearing practices is unsettling. Evidence of the various entanglements crops up from time to time—in the form of questionable voting outcomes or disputes about standing for shareholder lawsuits—but the underlying problems are systemic, not episodic. Our stock clearing system is a kludge.

This is an important moment for corporate law, however, because new technology is approaching a state where clearing and settlement systems may soon support traceable shares. The rise of distributed ledgers and blockchain technology is poised to allow for specific share identification and precise records of share provenance. This may sound like an uninteresting technical sideshow, but in Traceable Shares and Corporate Law (Northwestern University Law Review, v. 113, Forthcoming) I argue that the impact of traceable shares on corporate law will be profound. It will change the structure of shareholder lawsuits, alter the allocation of corporate governance rights, and require lawmakers to rethink fundamental principles of shareholder responsibility for corporate misdeeds.

More specifically, I argue that shareholder rights are limited by our current clearing systems in ways that many owners do not completely understand. Conversely, selling shareholders may evade responsibility for some corporate misdeeds because it has become too difficult to link individual sellers back to a specific share transfer. This has sometimes resulted in the imposition of corporate-level liability under a framework that is not entirely satisfactory because money is simply shifted from one pocket (that of all current shareholders) to another (that of wronged shareholders). Ex-shareholders, who may have benefitted from a transgression, are not tracked down or held accountable in any way.

The central player behind the scenes is the Depository Trust and Clearing Corporation (DTCC). Through numerous subsidiaries, DTCC takes physical possession of most stock certificates, serves as record owner for these shares, and clears trades by transferring beneficial ownership electronically from seller to buyer via bookkeeping adjustments. This approach has been crucial for managing an exploding volume of stock trades over the past five decades by avoiding a need to coordinate the handoff of physical certificates from seller to buyer. Importantly, however, DTCC’s warehouses of certificates are typically held in “unidentifiable fungible bulk.” This means that it is often impossible to specify who owns any given share of stock. Or, said differently, we do not trace shares.

In many cases, this doesn’t matter. The fiscal trade has still occurred at a clearly defined moment and price. And beneficial shareholders, the true economic owners of the stock, can exercise most governance rights by asking their brokers to send corporate proxy materials and instructing these same brokers how to vote their shares.

But this lack of share identification has meaningful implications for corporate law. Shareholders must sometimes argue that they bought shares that qualify for certain legal rights—such as an appraisal claim or a Securities Act Section 11 lawsuit—when resolution of this eligibility is indeterminate. Delays arise between a change in economic ownership and the transfer of the right to vote, which means that current shareholders may not always possess franchise rights for important matters of corporate governance. And the imposition of corporate damages for certain legal wrongs, such as fraud on the market, has been criticized for effectively requiring “innocent” shareholders—who purchase the stock after a misrepresentation occurs—to compensate plaintiffs. Untraceable selling shareholders, who may have benefited economically from the fraudulent misrepresentation, evade any loss. Might it be better to trace back the shares to those who owned the firm at the time of a misdeed and allow the injured shareholders to seek restitution from a previous investor? To date, these questions have remained academic because it has not been possible to make this sort of match.

We are at an interesting moment for corporate law, however, because back office technology is nearing a state where clearing systems can trace shares. Prevailing stock settlement processes are likely to experience a fundamental transformation in the coming years with the rise of distributed ledger technology and new methods for identifying the origin and provenance of shares. This reset would present new opportunities for reforming corporate governance and for rethinking foundational theories of corporate and shareholder liability. To be sure, such a change remains contingent, and new back-office paradigms are not inevitable. But revised settlement practices seem quite promising, and the era of unidentified fungible bulk may be drawing to a close.

If this transition does occur, the legal implications of traceable shares will be profound. Stock could be specifically identified in a way that allows buyers and sellers to know whether marketed shares would qualify for certain legal claims. Corporate voting processes could be streamlined to mitigate (though not eliminate) voting pathologies. Faster transfer of traceable shares would also mean that delays between share exchange and the exercise of franchise rights might be dramatically eliminated to make corporate governance more responsive to shareholder interests. And fundamental principles of shareholder responsibility for corporate misdeeds may even need to be reexamined in the light that this new information could offer.

The full article is available for download here.

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